How to protect your portfolio against a market sell off

5 mins. to read

It’s oh so quiet… Not even a mouse is stirring. The Vix is back to very low levels, the stock market is bubbling over near all time highs, the economy is back on track, QE rolls on… It’s safe to go on holiday. Or so you think…

Aside from a recent June swoon, equities have been rising in a steady fashion pretty much since the beginning of the year and investors, as evidenced by the AAII survey and the VIX chart below, it seems feel confident and serene. Everybody is now a successful stock picker and it doesn’t matter whether he beats the market or not as a return of 10% is still a huge increase over cash rates of effectively zero.

3 yr Vix chart

Latest AAII survey

It is precisely al times like this, that investors are most exposed. Time and time again, history has shown that the best times (and paradoxically the safest from a capital preservation perspective) to buy is when there is worry around, valuations are low, the vix is high and stocks are depressed. Late stage bull markets lull people into a false sense of security as prices that have risen for long periods condition the mindset  (cognitive dissonance) to expect more of the same. But again, history shows that investors should be getting progressively more worried with late in the day price rises.

Summer time is also a more dangerous time of the year as market liquidity often dries up and share movements may be a little more erratic – witness the events of summer 2011 that clobbered the markets in dramatic fashion. If you are planning to go away for a week or two, don’t be fooled by this all pervading quietness, it may be worth considering taking some steps to avoid impairing your peaceful break. Simple measures may avoid huge trouble.

Let’s revisit what happened two years ago. It was one of those quiet summers with risks supposedly “massaged away” by central banks what with their large cash injections and yet, something went really wrong. It started with the S&P downgrade of the US’s AAA credit rating and in just two weeks the S&P 500 lost 15%. During the same period, the FTSE edged down from 5,935 to 5,069, a decline of 866 points, also around 15%. With the FTSE declining that much, can you imagine what happened to individual stocks, those with betas of 2 or 3? Well, a sweet holiday would have been turned into a bitter nightmare…

Fortunately, there are tools allowing you to protect yourself against such situations, especially when you don’t have the time to carefully manage your holdings, as you’re more concerned, quite rightly, with the hot sun, the revitalizing ocean and a cold beer!

One course of action would be to close all your holdings at once just before starting your vacation. That would also mean having to re-purchase everything when returning from holidays and paying for the bid-ask spread again. You do have other options available however. Yes, options!

Simply purchasing an index Put option or constructing other strategies, ie a 1 X 2 Calendar Put Spreads is another route – are much, much les costly.

The best way to start, is to look at the correlation between your portfolio and the market. The key question to ask is: By how much would my portfolio move by each 1pc change in the market? Essentially, you are analysing your portfolio’s beta. If for example your portfolio beta were equal to 2, then to replicate its performance you would need to hedge yourself via index futures or options to a value of twice your portfolio. The idea is simple – a beta of 2 means your portfolio can be expected to rise by 2% for every 1% rise in the market.

Let’s take an example situation. Suppose your holdings are as depicted in the table below.

Let’s say you hold AMZN, EBAY, and CAT, which at current prices are valued at $22,525. Beta for the whole portfolio is 1.42. It’s easy to estimate the portfolio beta – you should take a weighted average of individual betas.

Let’s now consider the S&P 500 as the market surrogate. It currently trades at 1,690. To replicate your portfolio with a position in the market, you should buy a total of $22,525 X 1.42 or $32,021 of S&P exposure. These two portfolios should the perform in a  roughly similar manner.

Now, we just need to revisit options theory and get one simple and effective strategy – the protective put. This strategy consists of buying a put option on an instrument we already own. This way, if the stock goes down, the put will protect us while still allowing for upside potential. But on which asset will we be purchasing a put? Simple. We have illustrated how we could replicate our portfolio with a market position, now all we have to do is to buy puts on the S&P 500 index. As we have a portfolio holding equivalent to approx $32000 S&P 500 shares, we could buy 18.95 ($32,000 / 1690) put options on the SPDR ETF.

We decide to hedge as tightly as possible and so consider here a near-the-money put option with expiry date set to September and strike at 1,695. To buy 18.95 options, the total cost amounts to $746.53.

Now, let’s think about a situation similar to what happened two years ago – a large movement of 15% in the S&P 500, and the impact on our portfolio.

If the S&P 500 rises 15%, your option will expire worthless. Instead of gaining $4,803.15, your net gain is thus reduced by the option premium. However, if the S&P 500 declines as two years ago, you end with a loss of $651.79, instead of a huge loss of $4,803.15. The option effectively insures your portfolio. Note that you still lose $651.79.

Deciding whether you will have peace of mind during your ‘jollies’ or take risks is a decision you have at your hands. It’s your call (or put)!

To learn more about using options then click the image below for your free comprehensive guide on how to get started.

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